Key federal tax aid for homeowners in danger of expiration

Congress carved out a special exception for owner-occupied housing for five years, and that exception was later extended through Dec. 31. What happens if it expires?

Congress carved out a special exception for owner-occupied housing for five years, and that exception was later extended through Dec. 31. What happens if it expires? (Paul Sakuma / AP)

Kenneth R. Harney

WASHINGTON — Haven't we seen this movie before? On Capitol Hill for the second year in a row, key federal tax assistance for homeowners is heading for expiration within weeks. And there's no sign that Congress plans — or has the minimal political will — to do anything about it.

In fact, the prospects for extension of popular mortgage-forgiveness debt relief and deductions for mortgage insurance payments and home energy efficiency improvements appear to be more dire than they were last year at this time, when at least there was a formal bill pending to extend them.

This year there is none at the moment. The House and Senate are trying to figure out a budget but are also considering overhauling the entire federal tax system, which could mean that a long list of special-interest tax preferences — including for housing — might be sucked into the tax overhaul vortex and not revived if they expire as scheduled Dec. 31.

Robert Dietz, vice president for tax policy issues at the National Assn. of Home Builders, says the name of the movie is "Groundhog Day" — the Bill Murray classic about deja vu all over again. Remember last year's New Year's Eve "fiscal cliff" game of chicken that wasn't resolved until the wee hours of Jan. 1? The tax benefits for homeowners were ultimately extended, but only for a year. Whether that's possible again in late December is in doubt.

What's at stake here? Begin with tax treatment of mortgage debt relief. Before Congress changed the law in 2007, any borrower who had a debt canceled by a creditor would have to report the amount forgiven as ordinary income, subject to federal taxation. If a mortgage lender chose to reduce a homeowner's principal balance as part of a loan modification — say by cutting $50,000 off the mortgage balance — the IRS would treat that $50,000 as fully taxable income.

That's despite the fact that the owner never actually received $50,000 in cash, and despite the fact that it was highly likely the owner was already in distress on the loan, facing financial challenges that made payments on the previous balance difficult.

Congress carved out a special exception for owner-occupied housing for five years, and that exception was later extended through Dec. 31. What happens if it expires? It would mean that thousands of people who are in the process of doing short sales on their homes but won't close until 2014 may be subject to income taxes on the amounts their lenders cancel as part of the transaction. Underwater owners who sign up for short sales in 2014 — or owners who receive cancellation of debt as part of loan modifications — would all be subject to harsh taxes on their phantom "income."

In California, however, owners waiting for short sales to close appear to be in the clear.

A recent advice letter from the IRS clarified that California homeowners who sell their houses in lender-approved short sales won't be subject to a tax bill on the canceled mortgage debt even after the Congressional exemption ends. That's because of a 2011 California law that exempts forgiven mortgage debt in a short sale from being counted as income in the state.

But mortgage debt relief is hardly the only real estate tax benefit set to disappear at the end of December. Also scheduled to terminate unless extended:

•The 10% credit currently allowable for energy-saving improvements you make to your house, including qualified insulation, high-performance windows, doors and roofs. The credits have a lifetime cap of $500.

•The mortgage insurance premium write-off for anyone who takes out a home loan with a down payment below 20%. This includes conventional Fannie Mae-Freddie Mac loans, Federal Housing Administration-insured loans and VA guaranty fees. This may be particularly important next year for new buyers who use FHA loans because that agency has recently raised its insurance premiums significantly and withdrawn its previous rule that allowed borrowers to cancel their insurance premiums, as is standard in private mortgage insurance.

Best advice for anyone counting on one or more of these tax benefits in early 2014: Don't. This time around, it's possible that some of them may not come back.